Is your 401(k) plan breaking the law?

By Matthew Heimer

Actively managed mutual funds almost always charge higher fees than comparable index funds, and far too often they don’t beat their benchmark indexes. That’s why many critics, including Encore contributor Alicia Munnell, have argued that active funds don’t belong in 401(k) plans, where their costs and inefficiencies eat into workers’ savings. This week, law professor James Kwak is amplifying this line of criticism—arguing that stocking a 401(k) with actively managed funds might actually be illegal.

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Fees this high ought to be illegal, says one prof.

James Kwak of the University of Connecticut School of Law makes the case in a paper published in the University of Pennsylvania Journal of Business Law (and summarizes it snazzily on the economics blog The Baseline Scenario, where he’s a frequent contributor). Using actively managed funds in asset classes where index funds are cheaper and perform better, Kwak argues, “violates the existing fiduciary duty of employers and plan trustees to invest participants’ money prudently,” making it theoretically illegal under the federal pension law known as ERISA.

Because of ERISA, Kwak notes, Congress wouldn’t have to pass new legislation to discourage the use of active funds. Instead, the Department of Labor would need to clarify its guidelines to state that such funds “create potential liability for plan fiduciaries.” (Plan members can already sue their employers for violating their retirement-plan fiduciary duty, though they rarely do.)

That expanded threat on its own would scare many companies away from using the funds – or, at the very least, put pressure on them to vet their active funds much more carefully and give employees lots of cheaper options. “Index funds would give Americans retirees more money and asset management companies less money,” Kwak concludes. “From a public policy perspective, that’s a good thing.” Of course, in a political system where financial-services companies wield enormous lobbying clout, that also makes any such reform a long shot.

About Encore

Encore looks at the changing nature of retirement, from new rules and guidelines for financial security to the shifting identities, needs and priorities of people saving for and living in retirement. Our lead blogger is editor Matthew Heimer, and frequent contributors include editor Amy Hoak, writer Catey Hill, and MarketWatch columnists Elizabeth O’Brien, Robert Powell and Andrea Coombes. Encore also features regular commentary from The Wall Street Journal retirement columnists Glenn Ruffenach and Anne Tergesen and the Director of the Center for Retirement Research at Boston College, Alicia H. Munnell.